High Times for High-Yield Funds

The high-yield space should continue to outpace corporates and Treasuries

This has been an incredible year for high-yield funds. The Fidelity Capital & Income Fund (MUTF:FAGIX) and the iShares iBoxx $ High-Yield Corporate Bond Fund (NYSE:HYG) have each returned almost 20% over the past 12 months, and currently yield around 5%. Both are rated “4 Stars” or higher by LB Fund Ratings.

The short answer is no. We don’t believe that either fund can replicate the tremendous gains of the last year.

High-yield bonds have been a tremendous beneficiary of central bank action. Last year the market was very concerned about the U.S. economy sliding backward and the euro collapsing. Investors wanted to put their money in only the safest possible investments and limit portfolio risk. But since then the Federal Reserve and European Central Bank have flooded the market with dollars and euros. Their actions have removed a tremendous amount of the fear from the markets, and investors have been more comfortable investing in riskier bonds. This shift accounts for much of the recent gains.

But even without the returns spurred by a flight to risk, high-yield bonds should outperform corporate and Treasury bonds going forward. The key will be the default rate on high-yield bonds. If the default rate stays under 4% (the historical norm), high-yield should provide a better return than corporate and government bond funds. Put another way, high-yield bonds look attractive as long as the U.S. does not fall into a recession or there is another major economic surprise.